0 оценок0% нашли этот документ полезным (0 голосов)

8 просмотров13 страницBank pay caps

Feb 18, 2015

© © All Rights Reserved

PDF, TXT или читайте онлайн в Scribd

Bank pay caps

© All Rights Reserved

0 оценок0% нашли этот документ полезным (0 голосов)

8 просмотров13 страницBank pay caps

© All Rights Reserved

Вы находитесь на странице: 1из 13

journal homepage: www.elsevier.com/locate/jbf

John Thanassoulis

Warwick Business School, University of Warwick, United Kingdom1

a r t i c l e

i n f o

Article history:

Received 13 June 2013

Accepted 4 April 2014

Available online xxxx

JEL classication:

G01

G21

G38

a b s t r a c t

This paper studies the consequences of a regulatory pay cap in proportion to assets on bank risk, bank

value, and bank asset allocations. The cap is shown to lower banks risk and raise banks values by acting

against a competitive externality in the labour market. The risk reduction is achieved without the possibility of reduced lending from a Tier 1 increase. The cap encourages diversication and reduces the need a

bank has to focus on a limited number of asset classes. The cap can be used for Macroprudential Regulation to encourage banks to move resources away from wholesale banking to the retail banking sector.

Such an intervention would be targeted: in 2009 a 20% reduction in remuneration would have been

equivalent to more than 150 basis points of extra Tier 1 for UBS, for example.

2014 Elsevier B.V. All rights reserved.

Keywords:

Bank regulation

Financial stability

Bankers pay

Bonus caps

Capital conservation buffer

1. Introduction

The remuneration of bankers and executives in the nancial

sector is the focus of signicant regulatory attention in the UK,

EU and globally. Many are concerned that the level and structure

of pay contributes to the riskiness of banks. This concern has

inspired the Financial Stability Boards Principles for Sound Compensation Practices; the adoption by the European Union of the 1-to-1

Bonus Rule; and the adoption in Basel III of a Capital Conservation

Buffer which prevents banks making some remuneration payments

if their Tier 1 capital should fall below a specied level.2 The level

of pay is indeed a signicant cost for banks. Thanassoulis (2012,

Figs. 1, 3, and IA.1) documents that for a substantial minority of

nancial institutions remuneration exceeds 30% of shareholder

equity; while non-nancial rms rarely pay this much. For some

nancial institutions pay as a proportion of shareholder equity is

much higher and sometimes in excess of 80% of shareholder

equity.

1

Oxford-Man Institute, University of Oxford, Associate Member and Nufeld

College, University of Oxford, Associate Member.

Tel.: +44 2476528098.

E-mail address: john.thanassoulis@wbs.ac.uk

URL: https://sites.google.com/site/thanassoulis/

2

For discussions of these interventions please see FSB (2009), Thanassoulis (2013b)

and BCBS (2010).

bankers in proportion to the risk weighted assets they control.

Such a cap could be targeted, affecting some sectors, such as the

wholesale side, and not others, such as the retail side. Thus the

cap can work with existing regulatory attempts to treat wholesale

and retail banking separately (the Independent Commission on

Banking ring-fence in the UK for example).

The analysis demonstrates that a variable pay cap in proportion

to assets leans against the competitive externality which drives

pay up. Such a cap acts to lower aggregate remuneration. Hence

banks will have increased resilience to shocks on the value of their

assets due to their reduced cost base. This reduction in bank risk is

achieved whilst increasing bank values.

In principle banks can always be made less risky by increasing

their capital adequacy ratio. But by encouraging banks to meet

such requirements by either avoiding lending risk or reducing

lending, such a direct intervention has a cost. The intervention in

the labour market for banks increases bank values and does not

compromise lending. Further, to the extent that there is a broader

desire to intervene in the labour market for bankers, it would be

desirable if any such intervention had the effect of improving

nancial stability.

Basel III has determined, through the Capital Conservation Buffer,

that banks incentives to pay out rather than retain earnings needs

to be managed. Leading scholars have argued that the amount

banks paid out in share buybacks and dividends was so large as

http://dx.doi.org/10.1016/j.jbankn.2014.04.004

0378-4266/ 2014 Elsevier B.V. All rights reserved.

Please cite this article in press as: Thanassoulis, J. Bank pay caps, bank risk, and macroprudential regulation. J. Bank Finance (2014), http://dx.doi.org/

10.1016/j.jbankn.2014.04.004

Table 1

Remuneration reduction expressed as a gain in Tier 1 ratio.

Reduction in aggregate bank remuneration

5%

10%

15%

20%

25%

30%

19

28

37

47

56

Notes: The table expresses the money saved by a hypothetical reduction in the aggregate pay bill expressed as the equivalent increase in Tier 1 equity. This is calculated by

determining the dollar saving from a given percentage reduction in the total pay bill and dividing by the total risk weighted assets. Data from Bloomberg, see Footnote 3.

nancial crisis (Acharya et al., 2009). Thanassoulis (2012) documents that the banks in this study typically paid out double the

amount in remuneration than they did on share buybacks and dividends, and the shareholder payments only grew to be comparable

to remuneration during the last crisis. Thus if payments to shareholders became high enough to be a concern to the well functioning

of the banking system, the aggregate wage bill is at this elevated

level of note permanently. To determine more quantitatively the

scale of the relevance of remuneration to nancial stability let us

suppose the total remuneration bill could be reduced by some percentage. One can calculate how much of an increase in the Tier 1

capital ratio this reduction in remuneration would represent by

comparing funds saved to total risk weighted assets. As remuneration falls during crisis periods I focus on crisis years to avoid misleading estimates of the importance of remuneration. Table 1

considers the remuneration paid in 2008 and 2009, during the last

nancial crisis, by the top 100 global banks ranked by asset value in

2011.3 If the total remuneration bill was cut by only 5%, then this

would be equivalent to an average increase in Tier 1 equity levels

of 9 basis points. If the remuneration bill could be cut by 20% then

the equivalent increase in the Tier 1 ratio would be 37 basis points

on average.

Table 1 demonstrates that lowering pay has only a modest effect

on an average banks resilience. The average however hides wide

variation amongst individual banks. Thus an intervention on pay

would be targeted. It would make the banks with the most unsafe

pay levels, safer. Fig. 1 displays the identity of the 20 banks (in

the top 100) who would have been helped most by a 20% reduction

in remuneration costs on their 2009 remuneration bill. Fig. 1 demonstrates that an intervention in the level of remuneration would

have helped some major household names which were the focus

of considerable regulatory attention during the crisis. For example,

a 20% reduction in the remuneration bill in 2009 would have been

equivalent to a Tier 1 increase at UBS of 1.5% (150 basis points), 1.3%

for Credit Suisse, and over 0.8% for Deutsche Bank. These are significant gures in the context of the Tier 1 requirements of Basel III.

Thus an intervention which lowered market remuneration levels

and increased bank values would have an arguably signicant and

targeted effect of lowering risk in the nancial system.

In a market, such as the labour market for bankers services,

competition to hire scarce talent leads to an externality. The market level of remuneration will be determined by the institution

which is the marginal bidder for the banker. By bidding to hire a

banker unsuccessfully, the marginal bidding bank drives up the

market rate of pay in the nancial sector. The bidding is a pecuniary externality: the banker gains, the employing bank loses. However, in addition the employing banks fragility to market stress is

increased by increases in its cost base. This lowers the value of the

employing bank further. This latter competitive externality represents a market failure. A bank failure makes other bank failures

more likely, and in addition can have negative consequences for

3

The data sample is the top 100 listed institutions in Bloomberg by total assets in

2011 for which relevant data exists and whose activities include banking. Only group

entities were included; public institutions such as central banks and development

banks were excluded. Of the 100, a sample of 80 banks remain. The list includes the

31 Globally Systemically Important Financial Institutions dened by FSB (2011).

the importance of the market failure.

A cap on pay in proportion to assets impacts on the marginal

bidding bank more than the employing bank. As pay in a given

business line rises in proportion to the resources or assets being

managed, in equilibrium the marginal bidding bank does not have

a sufciently large pot of assets to attract the banker, and so is

unwilling to offer a large enough expected payment. The bank

which succeeds in hiring the banker will be able to do so at a lower

bonus rate as it adjusts the rate for the fact that it has a larger pot

of assets, and/or is an otherwise more desirable place to work. A

cap on the size of remuneration in relation to assets therefore

impacts the ability of the marginal bidder to drive up pay. Hence

the level of pay in the whole market is reduced.

As the proposed cap is on total remuneration, the measure

allows the bank to structure pay in the manner it considers optimal. Risk sharing features, such as bonuses, can be fully preserved

(Thanassoulis (2012)), as there is no requirement to force xed

wages up within the cap.

A cap on pay in proportion to assets will alter a banks asset allocation decisions. Within an individual business unit the manager

would like to be assigned as large a fraction of the banks assets

as possible as this would likely translate into the largest pay. This

effect exists whether or not there is a cap, and forces banks to

become focused on asset classes considered to be core so as to

secure the talent they desire. A cap in proportion to assets is more

binding on the marginal bidder than on the employing bank. Hence

each bank will nd that in its core business lines it is able to hire its

staff more cheaply as the marginal bidders are impeded in their

bidding. This allows the banks to row back on the specialisation

that had been necessary with unconstrained bidding, and so benet from increased diversication.

The cap could naturally also be a tool for macroprudential regulation as it can be used to encourage the re-targeting of banks

from some business lines to others. Suppose that a cap is imposed

on bankers managing wholesale assets, and not for those managing

assets on the retail side. Those banks which were the runners-up to

employ the best wholesale bankers become less aggressive bidders

due to the pay cap. This lowers the remuneration level of wholesale bankers and allows the banks which specialised in wholesale

banking to devote more of their assets to retail banking so as to

benet from diversication. Secondly some universal banks will

be competing against other non-bank nancial institutions which

may be regulated under different rules. The presence of these institutions outside the regulatory net strengthens the macroprudential

tool. Regulated banks would be at a disadvantage in hiring the best

traders or wholesale bankers. Hence the expected return banks

would have from these wholesale activities would decline as the

banks would be unable to hire the most sought-after traders. Thus

banks would be even more incentivised to reassign assets at the

margin from wholesale towards retail banking.

2. Literature review

The objective of this paper is to investigate the consequences of

a regulatory pay cap on bank risk, bank value and bank asset allocation decisions. This work builds on Thanassoulis (2012) who

Please cite this article in press as: Thanassoulis, J. Bank pay caps, bank risk, and macroprudential regulation. J. Bank Finance (2014), http://dx.doi.org/

10.1016/j.jbankn.2014.04.004

Fig. 1. Equivalent gain in Tier 1 ratio for the 20 most affected banks. Notes: The graph documents the impact of a 20% reduction in remuneration in the crisis year 2009. The

reduction in the remuneration bill can be measured in terms of an increase in the Tier 1 ratio. The graph documents the impact of such a reduction in remuneration on the 20

most affected banks in the sample of the top 100 banks used in Table 1. These are banks which would gain most resilience if the remuneration level of bankers could have

been reduced. Data from Bloomberg, see Footnote 3.

labour market which drives up pay and so increases bank risk. In

this study I extend the Thanassoulis (2012) framework to study

the effects of a regulatory cap on total pay in proportion to assets.

Further I extend the study to consider multiple asset classes,

asset allocation, and macroprudential regulation. The model of a

competitive labour market used here builds on the seminal contributions of Gabaix and Landier (2008) and of Edmans et al. (2009).

Relative to these works I explicitly model the possibility of bank

failure arising from poor asset realisations, and so am in a position

to discuss bankers and their impact on nancial stability.

As in Wagner (2009), if the size of the pool of assets should fall

below some level, a default event occurs which results in extra

costs for the bank. Wagner however does not investigate the supply side competition for bankers and so is silent on banker pay in

general. The aim of this paper is to understand how intervention

in the labour market for bankers would alter bank risk.

There is little empirical evidence on the level of bankers pay

and on bank risk. Cheng et al. (2010) is a notable exception which

demonstrates that nancial institutions which have a high level of

aggregate pay, controlling for their size, are riskier on a suite of

measures. A complementary nding is offered by Fahlenbrach

and Stulz (2011) who demonstrate that bank CEOs with the largest

equity compensation were more likely to lead their banks to losses

in the nancial crisis. Other empirical research has in general

focused on CEO pay and incentives whereas our focus here is on

remuneration more widely.4

This analysis focuses on the aggregate level of risk which a bank

would knowingly allow their bankers to take on rather than the

risk choices of individual bankers. Other studies have focused on

how competition between banks affects the shape of the remuneration contracts offered, and so individual bankers incentives to

take risks. For example Thanassoulis (2013a) argues that competition for bankers drives pay up and can lead to an industry using

contracts which tolerate short-termism. This work provides a

4

See for example Llense (2010) on CEO pay for performance, and Edmans and

Gabaix (2011) on the relative value of contract design versus hiring the optimal

individual to be CEO.

rationale for forced deferral of pay conditional on results. By contrast, Foster and Young (2010) argue that any variable pay can be

gamed and can lead to risk being pushed into the tails. Raith

(2003) considers rms competing, rather than banks, and endogenises the level of bonus to incentivise effort. He shows that rms

with larger market shares increase the bonus incentives they offer.

Benabou and Tirole (2013) consider competing rms using contracts to screen workers by ability: the high ability workers are

given incentives to take excessive risks. Acharya et al. (2013) study

the incentives a banker has to move institution to avoid their

employer learning whether their performance was due to skill or

luck. The insights in these works are complementary to the analysis here as none of these analyses explore the impact of pay caps on

the labour market equilibrium.

3. The model

Suppose there are N banks who have assets in a given asset class

of S1 > S2 > > SN . Banks seek a banker who will maximise the

expected returns from their assets. If the banks assets in this class

should however shrink to be less than gS, for some g < 1, then the

bank incurs some extra costs. The parameter g measures a required

preservation rate on assets below which the bank, or its creditors,

take actions which generate a cost to the bank. This captures, for

example, the costs of forced asset sales to reimburse creditors, or

increased costs of capital. I refer to the case in which assets fall

below this critical level as a default event. I assume the banks costs

in the case of a default event are proportional to the initial level of

assets: kS. The functional form is chosen for tractability, but it is

not a key assumption. The key assumption is that costs of a default

event can arise if a banker shrinks the assets they are given to manage sufciently.

There are N bankers who can run this asset. They expect to grow

the assets they manage by a factor of a1 > a2 > > aN . Thus if

banker i is employed by bank j then the expected assets of bank j

at the end of the period will be ai Sj . An expected asset growth factor of ai 1 would imply that that banker i is only expected to

maintain the dollar value of the assets he or she manages. I assume

Please cite this article in press as: Thanassoulis, J. Bank pay caps, bank risk, and macroprudential regulation. J. Bank Finance (2014), http://dx.doi.org/

10.1016/j.jbankn.2014.04.004

Table 2

Proportion of remuneration received as bonus.

Total compensation bands

500 K to 1 mn

> 1 mn

2008

2009

% Base salary

% Bonus

% Base salary

% Bonus

19

9

81

91

24

11

76

89

Notes: Data reproduced from Financial Services Authority (2010, Table 1, Annex A3.8). The FSA required this information of UK staff for seven major international banking

groups, and six major UK banking groups. The sample consists of 2800 staff comprising, the FSA estimate, 70% of Code Staff in banks operating in the UK. That is staff whose

activities can have a material impact on their employing bank. The table demonstrates that, given the exibility, banks would choose to deliver the vast majority of pay in the

form of bonuses.

translations of each other so that bankers differ only in their skill.

Hence the density of asset growth factors delivered by banker n

can be written as fn x 1=an f x=an , where f is a density with

unit expectation implying that the expectation of fn is an . Integrating we have the cumulative distribution of the asset growth

factor given by F n v Fv =an . The outside option in the labour

market for bankers will be determined endogenously to this

model. In addition the bankers have the option of leaving this

labour market and, for example, moving to another industry or

location. I normalise this outside option to zero. Finally bankers

are assumed to be risk neutral. There is considerable evidence that

bankers may actually be risk loving (see the evidence contained in

Thanassoulis (2012)). However all that is required for the following

analysis is that bankers are not too risk averse.

As the bank is an expected prot maximiser, the shape of the

distribution of asset growth outcomes generated by the banker will

only be important if the resultant asset levels are low enough to

trigger a default event, leading to the extra costs described above.

In any empirically relevant calibration of this model, default will be

a low probability event. Hence the relevant probability will lie in

the tail of F n . I now follow Gabaix and Landier (2008) and

Thanassoulis (2012) and use Extreme Value Theory to characterise

the shape of a general distribution in its left tail. I assume that the

asset growth factor generated by the bankers is bounded below by

zero so that banks enjoy limited liability on their investments. In

this case the left hand tail of the distribution of asset growth factors can be approximated by

F n v G v =an c

Extreme Value Theory would require G to be a slowly varying function.5 I restrict to G > 0 being a constant. I require c P 1 so that the

distribution function takes a convex shape.

I restrict bankers to be paid in bonuses which are proportional

to the assets they control. Thanassoulis (2012, Proposition 1) demonstrates that banks, as modelled here, would prefer to pay fully in

bonuses rather than using xed wages as well as bonuses. Bonus

pay allows banks to share some of the risk of poor asset realizations with the bankers. This lowers the banks expected costs from

the possibility of realizations which trigger a default event. Table 2

presents evidence from the UK corroborating that this all bonus

restriction is a reasonable assumption, particularly for those earning the largest amounts. More recent regulatory interventions have

limited bonuses and required banks to pay staff using higher xed

wages.6 Table 2 shows that if banks are given the exibility they

would elect to pay staff overwhelmingly in the form of variable

bonuses.

This is not an explicit model of moral hazard, though the outcome of such models is compatible with these assumptions. As

5

limv !0 Gt v =Gv 1 for any t > 0.

6

See Thanassoulis (2013b) for a discussion of the European 1-to-1 bonus

regulation.

pay is delivered in the form of variable pay conditional on performance, managers are fully incentivised. The bonus rates delivered

by this model would be in excess of any bonus rates required by an

explicit model of incentives and moral hazard. Suppressing the

subscripts momentarily, if a bank with assets S hires a banker of

type a on bonus rate q then the banker expects to receive dollar

remuneration of q aS. The expected asset level of the bank at

the end of the period, gross of the cost of any default event, is

a1 qS. Suppose the realisation of the asset growth factor is a.

There is a default event if the realisation, a1 qS < gS. Using

(1), the probability of this is Fg=1 q G g=a1 qc . Hence

the expected value of the bank at the end of the period is EV

where

EV a1 qS kSG

c

a1 q

Each bank will seek to maximise this expected value. A cap on the

remuneration in proportion to assets is equivalent to setting a maximum value for the bonus rate, q.

There is a competitive labour market for bankers. Banks bid

against each other to hire a banker to run their assets. Each bank

can offer a given banker a targeted bonus rate q which will be

applied to the realized level of assets the banker manages. The

offers are banker specic so that more able bankers can be offered

more generous terms. The market is assumed to result in a Walrasian equilibrium where an individuals pay is set by the marginal

bidder for their services. This can be modelled as the banks bidding

for the bankers in a simultaneous ascending auction (see

Thanassoulis (2012, 2013a)).

Finally I assume that the total size of each banks balance sheet

is exogenous. The assumption that balance sheets are exogenous is

equivalent to an assumption that the Board of a Bank would not

decide to change their aggregate size and debt-to-equity ratio to

allow an individual to be hired. Banks may well decide to alter

their asset allocation decisions within the envelope of their chosen

balance sheet size. We will explore this in detail below.7

3.1. Discussion of key assumptions

This model of banks competing for bankers is designed to be

tractable and to allow the key competitive forces which determine

pay levels to be clearly explained. Underlying the model are two

key assumptions. The rst is that the risk prole of the bank is

decided by the Board and not the banker, thus bonus rates do

not alter the tail risk of the institution. The second is that the bank

pays out remuneration to the banker, even if the banker delivers a

loss on the assets managed. This section will discuss each of these

assumptions in turn.

7

It would in principle be possible for a bank to stay within its regulatory Tier 1

ratios, and yet grow assets, to increase pay, by leveraging up with safe assets. This can

be managed here by appropriate risk weighting (Section 5.1). Further this more

general weakness in the regulatory regime is already being addressed through the

Leverage Ratio requirement in the Basel III framework.

10.1016/j.jbankn.2014.04.004

The Board of any bank will determine a desired risk prole for

their institution depending upon the return on equity they believe

their investors demand. The Board will seek to impose this risk

prole on the bank by using the corporate governance levers at

their disposal. These levers include the ability to manage the Value

at Risk (VaR) of individual bankers, often on a daily basis, and

broader asset allocation and hedging decisions. This study assumes

that these levers are sufcient to restrict the bankers to the desired

risk prole. Banker skill is therefore solely expressed as the

expected return given this shape of (tail) risk. If this risk control

assumption is violated then payment levels and bonus rates are

related to the risk prole of the institution. That is the tail risk F n

would be a function either of the bonus rate q, or of the expected

dollar remuneration.8 The dependence of tail risk on the remuneration would complicate the analysis offered here. When bidding to

hire a banker a large bank would be able to offer a low bonus rate

which, in the case of poor risk control, would lower the riskiness

of the bank. However larger banks will secure the services of more

talented bankers who have to be paid more, and this might raise

the riskiness of the institutions. The effect of poor risk control would

therefore be ambiguous for the solution of the model, even absent

any bonus caps. However the externalities described in this paper

would remain: the marginal bidder for a banker would increase

the fragility of the employing bank by raising her costs. This effect

would be exacerbated for larger banks if tail risk grows in remuneration levels, or may be mitigated if tail risk responds to bonus rates.

This study considers the impact of a cap on pay in proportion to

the assets a banker manages, and this cap is expressed as a cap on

the bonus rate payable. The intervention of a bonus rate cap studied here lowers bonus rates and overall pay levels. Therefore if

banks cannot fully control their tail risk then such an intervention

would mitigate the adverse effects of the poor risk control (see

Footnote 8). The lower bonus rates would reduce the incentive to

take excessive risk, to conduct fraud, to be myopic and to churn

across employers. Hence the analysis here understates the benets

of a bonus cap along all these avenues.

The second key assumption is that even if a bank should see its

assets shrink enough to trigger the costs of a default event through,

for example, forced asset sales, then the bank incurs a remuneration payment nonetheless. It might seem more realistic that a

banker who returns a lower level of assets than she began with

would not only not receive a bonus, but most likely lose her job.

If so then one might conclude that remuneration payments would

not add to a banks fragility, as when assets shrunk remuneration

payments would automatically be suspended until the threat of a

default event had passed. This reasoning is incomplete for a number of a reasons. Firstly, it may be that a banker who shrinks assets

loses her job, however consider the following thought experiment.

A banker running assets of 100 makes a 20% loss in the rst two

quarters and so is dismissed. The bank will need an alternative

banker to run these assets, suppose this replacement banker delivers 10% growth in the remaining two quarters. This second banker

would expect to be paid, and yet over the year assets have shrunk

from 100 down to 100 80% 110% 88, a reduction of 12%.

Thus remuneration is payable even if one believes that in banking

no failure is tolerated. Secondly, in reality a reduction in asset levels may well be due to bad luck and wider economic forces, rather

than poor banker skill. Indeed bankers would invariably argue this

8

This may be because high bonuses are used to separate high ability from low

ability bankers with the former incentivised to take excessive risks (Benabou and

Tirole, 2013; Bannier et al., 2013); or it may be because bankers game bonus schemes

through legitimate and illegitimate schemes (Foster and Young (2010)); or it may be

because bonuses provide an incentive for bankers to take early risks and then jump to

a new employer before their ability is revealed (Acharya et al. (2013)); or it may be

because bonuses encourage bankers to push risks into the future so inducing myopia

(Thanassoulis (2013a)).

bankers were paid very large sums on average in the recent past,

even after delivering negative returns on equity. Finally, unless

the bank formally enters bankruptcy protection, remuneration

contracts have to be honoured. A bank may also wish to honour

implicit rather than explicit commitments as any failure to do so

would alter all employees expectations of their pay and lead either

to demands to make implicit commitments explicit in contract

terms, or lead to the departure of staff. Thus I conclude that the

assumption that remuneration is payable even if a bank incurs

the costs of a default event is appropriate.

4. The no intervention benchmark

The level of pay a banker enjoys in the market is set by the marginal bidder for their services. A bank, in deciding how much to bid

for a banker, trades off the cost of employing the banker as against

the increase in value the banker generates, net of any changes to

the expected costs of a default event, as compared to the next best

hire. This section will determine the market rate of pay as a function of fundamentals.

Lemma 1. The bank with the nth largest assets to be managed will

hire the banker of the same rank n. Thus there will be positive

assortative matching.

The lemma follows by showing that a bank recruiting a manager to manage a large pot of assets would be willing to outbid a

bank which is recruiting a manager to oversee a smaller pot of

assets. This is not immediate as we are in a setting of non-transferable utility. Greater pay for a banker increases the expected costs of

default. This loss of value to the bank is not a gain to the banker.

The bank recruiting for the smaller set of assets will bid for their

rst choice of banker up to the point where the extra value generated on their assets as compared to the next best banker is just outweighed by the extra costs incurred in remuneration to the banker.

A bank recruiting for a larger set of assets would have the skill of

the better banker applied to a larger pot of assets. In addition,

increases in banker skill raise the expected asset growth and so

lower the probability of a default event. As default costs are

increasing in the size of the assets managed, the reduction in the

expected costs from default is more substantial for the bank

recruiting for a large pot of assets. Hence, for both reasons, the larger bank would value the better banker more, and so the bank

recruiting for the larger pot of assets would win in bidding for a

given banker. It follows, by induction, that there will be positive

assortative matching with bankers being assigned in equilibrium

to banks according to their rank.

In this benchmark case bankers are indifferent to the identity of

their employing bank and select their employer based on their

expected pay. The analysis offered here is essentially unchanged

if banks differ in non-nancial ways. For example banks may not

all offer an equally pleasant work environment, or banks may not

all offer equally compelling long-term career prospects. Suppose

that if a banker works at bank i, then bank specic differences raise

the utility generated for the banker by a factor of si . Thus if the

bonus rate were q then the bankers expected utility at bank i

would be 1 si qaSi . In this case it is as if the banker were managing utility adjusted assets of Ri 1 si Si . The banks could be

re-ordered according to fRi g. We would then have positive assortative matching by utility adjusted asset size. The results in this

paper would be unaffected by this change.

It follows that the marginal bidder for a banker of rank n is the

bank of rank n 1. We are therefore in a position to solve for the

market rate of remuneration for all of the bankers:

10.1016/j.jbankn.2014.04.004

will receive an expected payment of qi ai Si where the bonus rate qi is

given by:

qi

N

X

Sj aj1 aj

S

ai

ji1 i

bank i needs to pay to secure the banker of rank i depends upon

how much bank i 1, one down in the size league table, is willing

to bid. This is the marginal bid which needs to be matched. The

amount bank i 1 is willing to bid depends upon how much bank

i 1 must pay for its banker, which in turn depends upon the bidding of bank i 2. Hence the market rate can be established by

induction.

Having established the market rates of pay through Proposition

2 we can now interrogate the impact of regulatory interventions on

the entire market.

5. Effect of a pay cap in proportion to (risk weighted) assets

Let us now consider a policy intervention which caps the pay of

the individual running this asset class to no more than a proportion

v of assets. As I have assumed good corporate governance of bank

risk, the optimal bank risk prole which maximises returns is

unchanged. So the Extreme Value approximation (1) continues to

hold. Analysis of the new market equilibrium yields that such a

regulatory intervention would have the following effects.

Proposition 3. Consider a mandatory cap on the remuneration of the

banker equal to at most a bonus rate v as a proportion of assets.

1. The intervention lowers bank risk and raises bank values for all

except the smallest banks.

2. The lower the remuneration cap as a proportion of assets, the

greater the positive impact: higher bank values and lower bank risk.

3. The equilibrium allocation of bankers to banks is not affected, preserving allocative efciency.

In the labour market, banks compete with each other to hire

scarce talent. The market rate of pay for a banker will be determined by the institution which is the marginal bidder for the bankers services. By bidding to hire a banker unsuccessfully, poaching

banks drive up the market rate. The bidding is a pecuniary externality: the banker gains while the employing bank loses. However,

there is also an increase to the employing banks fragility to stress,

due to increases in its cost base. The larger cost base due to pay

increases the probability of a destruction of assets beyond the

required preservation level, and so increases the expected cost of

this event. This lowers the value of the employing bank further

and is a competitive externality. The cap works by leaning against

this competitive externality.

The cap impacts the marginal bidder for any given banker more

than the equilibrium employer. The remuneration enjoyed by a

banker is set by the amount the marginal bidding bank is prepared

to offer. Lemma 1 demonstrated that a larger bank would be willing to bid most, yielding positive assortative matching. It follows

that the bank which succeeded in hiring a banker in equilibrium

will have been able to do so at a lower rate as a proportion of

the assets the banker will run. The preferred bank adjusts the rate

it offers down for the fact that it offers the banker more resources

and opportunities to make prots, and/or is a more desirable place

to work.

A cap on pay in proportion to assets impacts the ability of the

marginal bidder to drive up pay. This lowers the marginal bid

and so allows the employing bank to hire the banker they would

do absent the cap, but at a lower level of remuneration. Hence

the market rate of pay is reduced. This reduction in pay increases

the value of the bank directly as they secure their equilibrium

employee more cheaply. In addition the reduction in the remuneration payable lowers the banks fragility as less remuneration must

be paid out when the bankers realized results are poor. This reduction in risk also raises the value of the bank.

As the employing bank now secures greater value from the

banker they hire, in equilibrium, to run their business unit, the surplus the bank is willing to bid to hire marginally better bankers is

reduced. The reduction in the competitive externality, and the corresponding reduction in bank risk therefore propagates upwards

through the labour market.

It follows from the logic of the intervention that the more

severe the cap, the greater the impact on the marginal bidder,

and so the greater is the gain for bank values, and the greater the

reduction in bank risk.

As the cap applies to all banks in proportion to assets, it does

not alter the matching of bankers to banks. No allocative inefciency is introduced into the system. However, the benet requires

macro not micro prudential regulation. No single entity can secure

the risk reduction and value increasing benets alone, as these

arise from altering the value of the competing remuneration offers

for any given banker.

The remuneration cap will lower market rates of pay for bankers. In principle one might therefore be concerned that this will

lead to a departure of workers from nance to other industries.

However education-adjusted wages enjoyed by workers in nance

have out-stripped other industries since 1990 by a premium of

between 50% and 250% for the highest paid employees (Philippon

and Reshef (2012)). Thus I conclude that wages in nance could fall

by some margin before the general equilibrium labour re-allocation effect would become a problem.

Salary caps have been a feature of sports remuneration in the

US. However these are different to the proposal outlined here.

Sports salary caps are the same across all teams,9 while the intervention studied here links pay caps to the size of the assets managed.

This link to bank size is critical in ensuring the cap targets the negative externality created by the marginal bidder, and ensuring that

the cap does not create a distortion in the allocation of talented

bankers to banks.

Finally, it has been noted that the nancial sector has undergone a period of sustained consolidation and merger activity dating

back to before the 1990s.10 This consolidation in the banking sector

has been accompanied by a sharp increase in the size of the balance

sheets of the largest banks (Morrison and Wilhelm (2008)). The

model of the banking labour market we study here captures one reason bank mergers create value: the desire to grow the balance sheet

to allow more talented bankers to be hired. The pay cap studied here

does not necessarily strengthen this merger incentive. Whether it

does so depends on the particular parameter values.11

9

See for example 2013 NFL salary cap breakdown by team, USA Today, available

at http://www.usatoday.com/picture-gallery/sports/n/2013/09/13/2013-n-salarycap-breakdown-by-team/2808245/.

10

For example, Bank for International Settlements (2001, Table 1.1, p34) document

that in 1990 there were 8 M&A deals involving banks in one of the 13 countries

studied with a value in excess of $1 bn, and the average value of these deals was

$26.5 bn. Over the decade this activity grew, and by 1998 there were 58 M&A deals in

that year with a value in excess of $1 bn, and the average value of these deals had

risen to $431 bn.

11

For an example of merger becoming less protable with a bonus cap consider a

duopoly of banks. Merger (to monopoly) will have the merged bank hiring the best

banker and offering a bonus at the normalised rate of 0. This is unaffected by a bonus

cap. Pre-merger a bonus cap can increase the value of the larger bank, hence lowering

the incentive to merge.

10.1016/j.jbankn.2014.04.004

The analysis has explored the case of good corporate governance under which the risk prole of the bank is set to maximise

the banks value. To ensure the robustness of the regulatory pay

cap, I now consider how a banker would seek to distort the value

maximising risk prole of a bank if their objective was to maximise

the money available for remuneration.

In this Section I will use the PyleHartJaffee approach to modelling the bank as a portfolio manager.12 Formally suppose a bank

wishes to maximise the value generated from

m securities with the

returns on security j 2 f1; . . . ; mg denoted ~r j . If the bank selects allo

P

cations in dollars of xj then next periods assets will be e

S j xj~r j .

These returns are assumed jointly normally distributed with vector

of expected returns q and the variance-covariance matrix V. Hence

l E eS

X

xj qj

j

var e

S hx; Vxi

the bank can be decomposed into a function of only the rst two

moments of the returns distribution: U l; r2 . If the bank selects

the riskiness of her portfolio, as assumed here, then the rst order

condition of the banks optimisation problem would yield

@U @ l @U @ r2

0

@ l @xi @ r2 @xi

This can be written

in matrix notation as kq Vx 0 where

k @U=@ l=2 @U=@ r2 . Hence the bank would select an allocation of assets for the banker to manage proportional to V1 q.

I now assume that the banker managing these assets must be

paid an amount W for past performance. Suppose that any cap

on remuneration

applies to the weighted sum of security values

D

E

b; x with vector of weights b. Thus the pay cap regulation implies

D E

W 6 v b; x

To analyse the scope for banker induced distortion, suppose that the

banker can distort the risk prole of the bank, as long as he delivers

a value of the objective U l; r2 of at least R. As the banker wishes

to maximise his pay, his optimisation problem becomes

max

fx1 ;...;xm g

D

unaffected by a pay cap if the cap weights securities proportionally to

their expected returns (b parallel to the vector of expected returns q).

The banker will be tempted to alter the investment prole he

targets if doing so can allow more to be paid under the cap whilst

preserving the expected returns net of risk. Proposition 4 shows

that this is not possible if the weights used to measure the quantity

of assets are proportional to the expected returns on those assets.

Hence if assets are weighted proportionally to expected returns,

the assumptions of this analysis remain robust, even if the banker

selects his investment strategy so as to maximise pay.

This analysis parallels that underlying the derivation of optimal

risk weights in capital adequacy regulation (Rochet (1992)). In the

standard CAPM framework, the expected return on a security

rewards the investor for the securitys undiversiable risk. Hence

Proposition 4 captures that the weight accorded to a security in

12

The PyleHartJaffee approach was proposed in Pyle (1971) and Hart and Jaffee

(1974). The version used here is derived from Freixas and Rochet (2008, Section 8.4).

the pay cap should grow in that securitys systematic risk. Rochet

(1992) argues that risk weights in capital adequacy requirements

should be proportional to the expected returns to ensure that the

bank will invest in an efcient portfolio of assets given the limited

liability constraint. To the extent that the Basel risk weights capture

systematic risk, they are a convenient approximation to this rule.13

6. Asset allocation responses to a pay cap

Banks invest in many asset classes. The banker managing an

asset class can make greater prots from a larger pot of assets.

Hence, even absent pay regulation, there exists an incentive to

try to manage as many assets as possible. This implies that in the

absence of any remuneration cap banks are under pressure to raise

asset allocations to areas where they seek to hire the best bankers/

traders. This increased asset allocation has a cost however in terms

of reduced diversication and excessive concentration.

This section will demonstrate that a remuneration cap does not

strengthen this effect, but rather weakens this excessive concentration effect amongst evenly matched banks, and so creates an

incentive for banks to re-assign assets so as to better diversify.

The cap impacts the marginal bidder in any asset-class more than

the equilibrium employer. It therefore hampers the extent to

which a rival bank can drive up remuneration in any given asset

class. This reduces the need to focus assets on a limited number

of core areas, and so allows for greater gains from diversication.

I demonstrate these results through an extension of the model

to allow for multiple asset classes.

6.1. Extension to a model of multiple assets

The diversication effect of bonus caps is at its strongest when

the competing banks are close in size. Later in this Section I will discuss the case of banks of very different size. To demonstrate this

positive effect of bonus caps most simply, consider initially two

banks each with equal total balance sheet size of T. Consider a model

of two available asset classes, and within each asset class there are

two bankers who could run either banks allocation to the asset class.

The most able manager in each class has an expected growth factor

of a, the next best hire has an expected growth factor of b < a. The

bankers outside options continue to be normalised to zero. The asset

level realisations in each asset class are assumed to be independent.

Each bank must decide how to split its balance sheet between

the available asset classes, assigning S dollars to one asset class

and T S dollars to the other. To proxy for the benets of diversication parsimoniously I suppose that the banks gain value

c ST S on top of the assets realised within each asset class,

with the parameter c a constant greater than zero. The specic

functional form of diversication benet is for convenience, the

economic assumption is that diversication confers some benets

to the bank, and these benets fall away if the bank withdraws

from a given asset class. This assumption captures, for example,

that the volatility of returns in the normal course of business are

reduced which provides value for employee stock holders and

any other investors who are not fully diversied; alternatively

the assumption captures the effect of diminishing marginal returns

to any given asset class as more and more of the balance sheet is

used for that asset class. I model the banks as rst simultaneously

deciding their asset class allocations, and then competing to hire

the bankers as in the benchmark model given above.

13

However the risk weights offered in banking regulation are not a pure estimation

of systematic risk (Iannotta and Pennacchi (2012)). The Basel rules allow national

regulators some exibility in selecting risk weights, and where analysis is conducted

the risk weights are calculated to reect the overall expected loss conditional on a

default. The Basel risk weights will therefore be a good proxy for systematic risk only

to the extent that systematic risk is correlated with overall risk.

10.1016/j.jbankn.2014.04.004

Because of the symmetry of this initial problem I consider a

symmetrical allocation. I therefore consider an allocation of assets

in which each bank targets the best banker in a different asset class

by putting S > T=2 into the targeted asset class, and T S into the

remainder. The expected value of a bank which secures the

a-banker in its targeted class for a bonus of qa , and the b-banker

in the other business line for a bonus of qb is given by

V S; T S a1 qa S kSG

g

a1 qa

c

b 1 qb T S kT SG

c ST S

!c

b 1 qb

Eq. (5) captures the costs of a default event in any asset class. Such

an event occurs if the assets under management in the class shrink

to be less than g of their initial level. Under a pay cap we require

qa ; qb < v.

Proposition 5. As the cap on pay becomes more severe (v declines),

banks re-balance their asset allocation in the direction of making their

exposure more diversied and less asymmetric.

The asset allocation a bank makes is a trade off between giving

the most assets to managers who can produce the highest return,

set against the costs of over-specialisation. To understand the

result it is perhaps easiest to consider the reverse, and suppose that

a remuneration cap becomes less binding. As the remuneration cap

is removed, each bank nds itself subject to more aggressive bidding for the best banker from the bank which is under-weight in

that asset class. To continue to employ the a-banker in its targeted

asset class, each bank must match the more aggressive bidding.

This lowers the prots available from the asset class, and it

increases the risk of a default event as well. If the bank now

increases its asset allocation to its targeted area then it can lower

the proportion of the realised assets used for remuneration. This

increases the banks value from this asset class because its risk of

a default event is reduced. Hence each bank responds to a relaxation of the pay cap by focusing more on its target asset class in

defence against the now more aggressive rival bank.

Running the process in reverse we see that as the remuneration

cap becomes more severe, it is the institutions which are already

most devoted to the class that are least handicapped. The cap is

more binding on the marginal bidder in each asset class than on

the equilibrium employer. It therefore follows that the leading

institutions in the class are in a position to reduce their asset allocation as they can continue to employ the best staff with fewer

assets, and stand to gain the diversication benets by re-balancing towards other asset classes.

Hence an effect of the pay cap intervention is that it reduces the

pressure for similarly matched banks to excessively focus on their

core areas, as would be necessary with unconstrained bidding.

The cap instead creates a force for diversication amongst the

banks. This benecial effect becomes weaker as the banks become

more asymmetric in size. To see this suppose that the two banks

studied in this section become sufciently asymmetric in size that

the large bank can secure the a-banker in both asset classes. In this

case one can show that the optimal asset allocation will be unaffected by the presence, or otherwise, of a bonus cap.14 The analysis

14

Both banks would split their balance sheets equally between the asset classes to

maximise the diversication benets. If the bonus cap is binding, then the smaller

bank will bid at most a bonus rate of v. The larger bank would secure the a-banker in

each asset class at a bonus rate of vT 2 =T 1 where T 1 > T 2 denotes the size of the total

balance sheet. The equilibrium bonus falls in the bonus cap as per Proposition 3.

in this case exactly parallels the single asset class analysis in Section 5.

A bonus cap impacts the ability of the marginal bidder to drive up

remuneration in both asset classes, allowing the larger bank to lower

its risk and increase its value with no asset allocation distortion.

A cap on remuneration in proportion to assets can be applied to

some business lines and not to others. This section demonstrates

how such partial application of pay regulation can be used to retarget banks activities to certain asset classes. Suppose, as an

example, that for reasons outside of this model a regulator decided

that there was insufcient lending to the real economy via banks.15

In this case a pay cap in proportion to assets applied to bankers

working in wholesale banking, but not in retail banking, would alter

the equilibrium asset allocation decisions so that all banks refocus

assets away from wholesale and towards retail banking. Though a

pay cap is an instance of microprudential regulation, the effect

would be a macroprudential one as the resilience of all banks across

the system is improved.

Further banks are in competition with other Financial Institutions, such as hedge funds, to secure bankers/traders, and these

nancial institutions who do not possess a banking license are

often regulated under different rules. I will study the case of

incomplete regulatory coverage in Section 7.2. The existence of

nancial institutions outside the regulatory net, rather than being

a problem, can be used to further enhance the efcacy of pay-caps

as a macroprudential tool.

7.1. A model of partially applied pay cap regulation

Once again consider the model of Section 6 of two asset classes

and two bankers in each asset class with expected asset growth

factors a > b. For expositional purposes, and in keeping with the

motivating example, I will label the two asset classes r for retail

and w for wholesale banking. However the analysis applies to

any subdivision of banks activities. Generalising from Section 6, I

move away from symmetry and consider two banks with balance

sheets T r ; T w . I restrict attention to the interesting case in which

each bank secures just one of the a-bankers. Bank T r will specialise

in the r asset class (e.g. retail banking). It devotes Sr dollars to retail

banking, and T r Sr dollars to the alternative asset-class: wholesale banking. Similarly bank T w specialises in the w asset-class

(e.g. wholesale banking), and so devotes Sw dollars to its asset class

specialism (the w asset class). Bank T r assigns more dollars to the r

asset class than the rival bank, and in this sense specialises in the r

asset class (retail banking).

Each bank secures gains from diversication (as in Section 6)

proxied by c Sw T w Sw for the wholesale focused bank, and similarly for the retail focused bank.

The regulatory intervention I analyse here is a bonus rate cap v

applied to remuneration on the w-asset class only. If this bonus cap

is binding then it will affect the marginal bidding bank in the w-asset

class. Hence the cap implies that bank r is restricted in the bonus rate

it can offer to try and attract the a-wholesale banker. Bank r can offer

the a-wholesale banker at most expected pay of v aT r Sr given

its asset allocation choice. The bonus rate paid by bank w for the

wholesale banker will be below the cap (13). There is no cap on

bonuses offered to bankers in the retail banking asset class.

I again model the banks as rst simultaneously deciding their

asset class allocations, and then competing to hire the bankers as

15

Insufcient lending in the UK to Small and Medium sized Enterprises (SMEs) has

been a notable recent regulatory concern. See for example Funding for Lending

failure dismays BoE, Financial Times, March 11, 2013.

10.1016/j.jbankn.2014.04.004

benets of diversication large enough that

c > max

1 1

;

Sw Sr

k g c cc 1v2

G

2 a 1 vc2

assets between classes. The assumption is trivially satised if the

banks are large enough.

We are now in a position to study the effect a partially applied pay

cap has on the asset allocation decisions of the two banks. I denote

the best asset allocation response of bank w to bank r as Sw Sr and

vice-versa. Thus if bank r assigns assets Sr to its specialism (the r

asset-class, retail banking), and by implication assets T r Sr to

wholesale banking, then bank ws best response is to assign Sw Sr

to its asset-class specialism (the w asset class, wholesale banking).

Lemma 6. The best asset allocation responses of each bank are

strategic substitutes. Thus dSw Sr =dSr < 0.

The result builds on the logic of Section 6 and demonstrates the

strategic interaction between asset class allocation decisions. If

bank r should increase its allocation to its asset-class specialism

(r asset-class, retail banking), then by denition it is moving assets

away from the other asset class: wholesale banking. The rival bank

now faces a less aggressive bidder for the a-wholesale banker. As

explained in Section 6 the wholesale focused bank can now benet

from increased diversication and so reduces its focus to wholesale

banking. The wholesale focused bank therefore increases its allocation to retail banking. As there is no bonus rate cap on remuneration to retail bankers, there is now a second round effect making

bank w a more aggressive bidder for the a-retail banker. Therefore,

to protect its protability bank r optimally responds by further

increasing its asset allocation to retail banking also.

Bonus caps applied to wholesale banking can kick-start this reallocation process by inhibiting bank r from bidding up wholesale

banker bonuses:

Proposition 7. If a bonus cap applying only to one asset class is made

more severe, all banks increase their asset allocation to the alternative

asset class. Hence if a bonus rate cap v applying only to wholesale

banker remuneration is reduced, all banks increase their asset allocation to retail banking.

A bonus rate cap applied to one asset-class affects the marginal

bidders ability to drive up pay in this asset class. The retail-focused

bank is the smaller bank in the wholesale banking asset class, and

so it is the marginal bidder setting the remuneration level which

the wholesale-focused bank needs to match. A bonus rate cap for

bankers working in wholesale banking impedes the retail focused

bank from bidding up the remuneration of wholesale bankers. This

sets off the logic of Lemma 6. Namely the wholesale focused bank,

facing less intense competition to hire the a-wholesale banker, is

able to prot from diversication. Thus bank w, at the margin,

moves some assets away from wholesale and towards retail banking. This makes competition for the a-retail banker more intense,

and as there is no bonus cap to protect it, this leads to the retail

focused bank also repatriating some of its assets away from wholesale and towards retail banking. This effect is depicted graphically

in Fig. 2. Thus partially applied pay caps can be used to alter banks

asset allocation decisions through the economic cycle.

Fig. 2. Best response asset allocation functions. Notes: The curve Sw Sr captures the

best asset allocation response of the w focused bank on asset class w (wholesale

banking), in response to the allocation Sr of the r focused bank to the r asset class

(retail banking). The best response functions are strategic substitutes as the curves

slope down. As the bonus rate cap v on wholesale banker remuneration is made

more severe (v declines), the best response curve of the w bank is pulled down. The

best response curve of the r bank is not affected as there is no cap on retail banker

remuneration. Hence the equilibrium asset allocation to retail banking rises for

both banks.

therefore just one universal bank r active in both the r asset class

(e.g. retail banking) and the w asset class (e.g. wholesale banking).

The bank is once again regulated as to the remuneration it can pay

to bankers who manage assets within its wholesale banking book.

It is not regulated on payments to those managing retail banking

assets. Thus the pay cap regulation continues to be partially applied.

Now replace the universal bank w analysed in the section above

with a competing nancial institution active only in the w asset

class. I will refer to this institution, for the purposes of this example, as a hedge fund and label its assets in the class Sh . I assume this

h institution sits outside of the regulatory net and so is exempt

from the pay cap. (Otherwise the analysis above is trivially

extended). This model simply captures that banks have multiple

business units, and in some of the business units they will face rivals who come under a different regulatory regime. The benets of

diversication for bank r are again proxied by c Sr T r Sr if bank r

assigns Sr dollars to the retail banking book. In both asset classes

there continue to be two bankers with expected growth factors

a > b. (Only one retail banker will be required hence the a-retail

banker will be secured by bank r.)

The case of interest is where, absent any cap, the bank would

secure the better executive to run its wholesale business unit. Such

a bank is one which is vulnerable to the introduction of a remuneration cap which applies to it, but not its rival. To this end I restrict

attention to the case in which

Sh <

c c

Tr

1

g

g

a b kG

a

2 2c

b

This parameter restriction ensures that, absent any cap, the bank

would secure the a-banker for its wholesale banking book.

First I determine an upper bound on the size of the retail banking book in the absence of any regulation capping pay.

the a-banker to run the wholesale banking book. The bank will set its

retail banking book strictly smaller than Syr where

even with incomplete regulatory coverage, pay caps in proportion

to assets applied partially across asset classes, can be used effec-

Syr

c c

Tr

1

g

g

a b kG

a

2 2c

b

10.1016/j.jbankn.2014.04.004

10

contradiction, that the bank only succeeds in hiring the b-banker to

run the wholesale banking book. Under this assumption the value

of the bank can be determined by adapting (5) as:

c

g c

g

W r Sr aSr kSr G

bT r Sr kT r Sr G

a

b

|{z}

from retail book

c Sr T r Sr

Eq. (8) follows as both bankers will receive a normalised bonus rate

of zero. This value function is concave in the allocation of assets to

the retail banking book, Sr . Hence there is an optimal allocation

given by the rst order condition. This asset allocation is sufciently

large that the bank would have more assets in its wholesale banking

book than the hedge fund, given assumption (7). This delivers the

desired contradiction as the bank will outbid the hedge fund and

so secure the a-banker for its wholesale activities (Lemma 1).

It follows that, absent pay cap regulation, bank r will outbid the

hedge fund and hire the a-wholesale banker. As bank r must compete with the hedge fund to secure the wholesale banker, the awholesale banker receives higher remuneration than the a-retail

banker does. Thus, to protect its protability the retail bank diverts

assets to wholesale banking, shrinking its retail banking book. This

is not straightforward to show as the interaction between pay levels and bank default risk is not linear. Nevertheless it can be demonstrated that we have an upper bound on the retail banking book

in the absence of pay cap regulation, and this upper bound is given

in Lemma 8.

Proposition 9. If the bank is subject to a sufciently severe cap on

remuneration for the wholesale banking book then the bank will reallocate more assets to retail banking and reduce the size of its

wholesale banking book.

Proposition 9 considers a regulation which is sufciently severe

that the bank loses the best wholesale banker to the hedge fund. In

this setting the bank can secure bankers, but in wholesale banking

they are not the very best ones. As a result the expected growth

factor available from wholesale banking assets falls slightly, to

the lower level of b. The bank would now conduct its asset allocation decision as in the proof of Lemma 8 under the assumption that

it will secure the b-bankers for the wholesale banking book, and so

the optimal asset allocation can be found. At the asset allocation

stage the bank will choose, at the margin, to divert funds away

from the wholesale banking book and towards the retail banking

book as the returns from wholesale banking have diminished as

a result of the partially applied pay cap regulation. Proposition 9

captures that the incomplete regulatory coverage of remuneration

regulation can be turned to the regulators advantage. The ability to

use pay cap regulation as a macroprudential tool survives in the

presence of a porous regulatory net.

8. Conclusion

A variable cap on remuneration in proportion to risk weighted

assets lowers bank risk and raises bank values. Such a cap impacts

on the marginal bidder for a banker more than on the employing

bank. The implication is that the market rate of pay for bankers

declines, and so banks become less fragile as their cost base is

pulled down. By addressing a negative externality in the labour

market for bankers, the intervention also has the effect of dampening the pressure banks are under to focus resources on given asset

classes so as to secure better bankers. And the pay cap can be used

to achieve macroprudential objectives through the cycle as it can be

structured to encourage banks to refocus towards a subset of asset

Table 3

Numbers of employees targeted by intervention on top 20% of earners.

20% Of employees in 2009

UBS

Credit Suisse

Morgan Stanley

Deutsche Bank

Goldman Sachs

Citigroup

13,047

9520

12,278

15,411

6500

53,060

Notes: The table documents the numbers of employees which would have to be

captured by an intervention if it were targeted at the top 20% of earners in the

named banks in 2009. The data is drawn from Bloomberg and the dataset is that

used in Table 1 and Fig. 1. The banks displayed are a selection of household names

drawn from the top 20 banks documented in Fig. 1.

using appropriate risk weights, bankers incentives to abuse any

weakness in corporate governance failings to grow pay is mitigated.

Consider therefore a regulatory intervention which capped total

bank remuneration summed over wholesale bankers proportional

to each banks risk-weighted wholesale banking assets. Regulation

at the aggregate level is easier and less costly to implement than per

person caps. And yet such a cap will likely be implemented by

senior management on rank-and-le hiring decisions as a top down

rule. This is because the numbers of employees involved would

make micro-managing deviations from a general rule impractical

(see Table 3). Hence a cap at the bank level tackles the externality

described at the individual banker level, and likely generates the

consequences for bank values and bank risk studied here.

As a benchmark calculation let us suppose that remuneration in

banks adhered to a commonly experienced 80:20 rule (Sanders

(1988)) so that the 20% best paid bankers secure 80% of the remuneration. If the pay of these best paid executives could be lowered

by a quarter then this would equate to a 20% reduction in the overall remuneration bill, the effect of which was graphed in Fig. 1.

Such a reduction in 2009 would have been equivalent, in safety

terms, to an increase in the Tier 1 ratio of over 150 basis points

for the most affected institution (UBS).

The logic, described in this analysis, of the negative externality

banks exert on each other through the labour market exists in all

industries. Thus one might wonder if a similar pay cap regulation

would be advisable in other industries beyond nance. I do not

seek to take a stand on this question. However I note that the rationale for intervening beyond nance is weaker for at least two reasons. Firstly the nance industry is special as compared to other

areas of business due to the negative externalities it exposes society to when nancial rms fail. These impacts on society are not

formally part of this model and so this study does not offer a justication that pay caps in banking are worthwhile. I purely note

that the case for pay caps in proportion to assets is likely to be relatively stronger in banking than in other industries. Secondly, the

nancial sector has a larger remuneration bill as a proportion of

shareholder equity than other industries. It therefore follows that

the gain from a pay cap in terms of bank risk reduction is correspondingly greater than it would be in other industries.

Acknowledgements

I would like to thank the editor Ike Mathur, and an anonymous

referee for detailed comments which have greatly improved this

paper. I would further like to thank Sam Harrington, Su-Lian Ho,

Victoria Saporta, Matthew Willison, and the other members of

the Prudential Policy Division at the Bank of England for helpful

discussions. I would also like to thank the Bank of England for their

hospitality whilst I was undertaking this research. Finally I am

grateful to audiences at the Financial Globalization and Sustainable

Finance Conference, Cape Town, the IFS School of Finance, the CFA

10.1016/j.jbankn.2014.04.004

11

Belgium, the CFA London, the Atlanta Fed, WBS University of Warwick, University of Zurich, and Christ Church, Oxford University.

This work does not reect the view of the Bank of England or

any other named individuals. Any errors remain my own.

i. Let bank m be the bank with the greatest assets, conditional on

being smaller than bank is, which is affected by the cap. Thus

m 2 M and m > i. From (12) we have

ai Si qi

m1

X

Sj aj1 aj am1 qm1 Sm1

ji1

j 1. We wish to show that the bank with the larger pot of assets

in this business unit will secure the better banker. Suppose the

outside option of banker j is u. If bank i hires banker j at a bonus

rate qi;j then the bonus must satisfy aj qi;j Si u. Hence bank is

expected utility would be, from (2):

V ij aj 1 qi;j Si kSi G

aj 1 qi;j

!c

where:

V ij aj1 1 qi;j1 Si kSi G

!c

aj1 1 qi;j1

10

Setting (9) equal to (10), this has solution aj1 1 qi;j1

aj 1 qi;j . The maximum bid that bank i will make for banker

j 1 is therefore

qi;j1 1 aj =aj1 1 qi;j

11

ing to bid for banker j 1 as qi1;j1 1 aj =aj1 1 u= aj Si1 .

The lemma follows by demonstrating that bank i 1 is willing to

bid to higher levels of utility for banker j 1:

aj1 Si1 aj Si1 u

aj1 Si aj Si u

aj1 aj Si1 Si > 0

The inequality follows as, by assumption, Si1 > Si and aj1 > aj . It

follows that we have positive assortative matching. h

Proof of Proposition 2. Bank i 1 will be willing to bid for the

banker of rank i a bonus qi1;i given by (11) as

qi1;i 1 ai1 =ai 1 qi1 . This is the marginal bid for banker

i. Hence bank i will match the marginal bidder:

PN

12

The ultimate outside option of leaving the industry for all the bankers is normalised to 0 which yields qN 0. The result follows. h

m1

X

Sj aj1 aj am1 vSm by 13

14

ji1

v < quncapped

. Hence the bonus paid by bank i declines as a result

m1

of the cap. The risk of a bank incurring a default event is

Gg=a1 qc . As the bonus q declines this probability also

declines. The value of the bank rises by inspection of (2). Hence

we have the rst result.

We now turn to the second result. We wish to show that the

bonus payable by bank i declines as the cap, v, falls. Suppose rst

that a reduction in the cap v does not alter the identify of the

highest rank bank, with assets in this business line smaller than i,

which is affected by the cap. If so the bonus bank i pays is given by

(14). This moves monotonically with v delivering the result.

Suppose now the cap is so stringent that it affects more banks.

Thus suppose the identity of the highest rank bank, with assets

~ where

smaller than i, which is affected by the cap becomes bank m

~ < m. The bonus payable by bank i can therefore be written,

i<m

from (12) as

ai Si qi

~

m1

X

Sj aj1 aj am1

qm1

Sm1

~

~

~

ji1

~ 1 pays

The proof now follows by observing that the bonus bank m

~ This follows as

declines as a result of the cap now affecting bank m.

~ for banker m

~ 1 is reduced by the cap. Hence the

the bid of bank m

bonus paid by i again moves monotonically in v. This delivers the

result.

Finally, as the cap applies to all banks, the positive assortative

matching result of Lemma 1 is unaffected. There is no re-ranking of

the banks and so the allocation of bankers to banks is

unaffected. h

Proof of Proposition 4. Given the maximisation problem (4) forD

E

h D

E

i

mulate the Lagrangian L v b; x g U x; q ; hx; Vxi R

with Lagrange multiplier g. The rst order condition then yields

an expression for the optimal allocation x :

vb g

@U

@U

q 2 2 Vx 0

@l

@r

Hence we have

Proof of Proposition 3. We rst show that a bank will pay a

lower bonus rate to the banker they hire than they would bid

for a better banker. This follows from (11) as qi;i1 qi

1 qi 1 ai =ai1 > 0. Hence a cap will be binding on a banks

bidding for better staff.

Suppose that the cap affects the bidding of bank j for the better

banker j 1 for the subset of banks j 2 M. If bank j 2 M then the bid

for banker j 1 is a bonus qj;j1 v as the cap is binding. Hence

bank j 1 will secure banker j 1 at a bonus such that it matches

the utility offered by bank j : aj1 Sj v aj1 Sj1 qj1 , yielding

qj1 v Sj =Sj1 < v

13

by the cap, then the required bonus will also be unaffected by the

cap, and is given by (12).

x

1

@U

1

V

g

q

v

b

2g@U=@ r2

@l

The direction of the vector x varies in the cap v unless b is proportional to q yielding the result. h

Proof of Proposition 5. First we note that both banks choosing

exactly the same allocation in all asset classes so that they set

S T=2 is not an equilibrium. As the banks are equal in size, competition for the a-banker would push their expected pay up to the

point where both banks were indifferent between the a and b

banker. Thus it would be as if both hired b-bankers. This is

dominated by one bank moving e of their balance sheet to one of

the business lines. They would then secure some benet from an

a-banker which increases their prot.

10.1016/j.jbankn.2014.04.004

12

The bank with the smaller asset allocation in any given class

will have T S in the asset class. If the cap on remuneration is

binding v < 1 b=a then the bonus is limited and so the bid is

capped at expected remuneration of avT S. Hence the bank

with the larger pot of assets secures the a-banker by offering a

bonus rate of q vT S=S. The bank with a smaller pot of assets

in any given class will recruit the b-banker for a bonus of 0 as the

outside option is normalised to 0.

To identify the optimal asset allocation S we must ensure there is

no incentive to unilaterally deviate to a

different allocation e

S. Denote

the value from such a deviation by V e

S; T S where the second

argument captures the rivals weight in the asset class. From (5):

1c

B

C

T S e

g

C

S ke

V e

S; T S a 1 v

SGB

@

A

e

S

TS

a 1v e

S

|{z}

.

@ 2 V .@ e

S@ e

S < 0. By the same logic as for @ 2 V=@ e

S@ v we have

@2V @ e

S@ T S > 0. Combining we have determined that

dS=dv > 0, so the result is proved. h

Proof of Lemma 6. I will prove the result for bank w, the result for

bank r follows analogously. Bank r is subject to a bonus cap of v in

its bidding for the a-wholesale banker. This yields expected remuneration of avT r Sr . Hence bank w secures the a-wholesale

banker by offering a bonus rate of q vT r Sr =Sw . Hence from

(5) the value of bank w is:

0

1c

T r Sr

g

iA

Sw kSw G@ h

V w Sw ;T r Sr a 1 v

Sw

r

a 1 v T rSS

w

|{z}

c

bT w Sw kT w Sw G

gc

ce

S Te

S b T e

S k T e

S G

b

15

e

e

asset allocation

S. This follows if the term i is convex in S. To test

this dene h e

S by

h e

S :

concave in the asset allocation Sw . Hence the best response of bank

w is given by the rst order condition, @V w =@Sw 0. Analogously to

(16):

0 a b cT w 2Sw kG

g

a av TS

e

kG

This is a hyperbola in e

S. Consider the arm in which e

S > vT S

e

which is the relevant one as S > T S. This curve is positive, down

h ic

. As c P 1

wards sloping and convex. Now consider f e

S e

S h e

S

a sufcient condition for this curve to be convex is if

Thus the objective function of the bank is concave and so has a unique

maximand given by the rst order condition. Hence an equilibrium is

achieved when @V=@ e

S evaluated at e

S S equals zero. This gives:

c

@V

g

S; T S 0 a cT 2S b kG

b

@e

S

!c (

kG

g

a 1 v TS

S

1 c

v TS

S

1 v TS

S

@h

b

1c1

1

r

1 v T rSS

w

iA

T r Sr

1 c 1v

Sw

18

@S2w

V w Sw ; T r Sr

dSw

@

V w Sw ; T r Sr 0

dSr @Sw @ T r Sr

.

@ 2 V @S2w < 0. By algebraic manipulation one can conrm that

@ 2 V w =@Sw @ T r Sr > 0 which implies that dSw Sr =dSr < 0 as

required. h

Proof of Proposition 7. Lemma 6 shows that the asset allocation

decisions are strategic substitutes. We rst show that decreasing

the bonus cap v pushes the reaction function of bank w down.

)

16

units, S and T S, implicitly as a function of v.

We wish to determine the change in the asset allocation to the

over-weight asset in equilibrium. We have @V Sv; T Sv=

@e

S 0 which denes S as a function of v. We therefore have

g c

c

I now show that the best response curve, Sw Sr is downwards sloping to yield the required result. Taking differentials we have

2gvT S

2gvT S

0

00

S e

Sh e

S

S

0 < 2h e

2 e

3

a ~S vT S

a eS vT S

cSw T w Sw 17

(

)

@2V

dS @ 2 V S; T S @ 2 V S; T S

@e

@e

@e

S@ v dv

S@ e

S

S@ T S

.

By algebraic manipulation of (16), @ 2 V @ e

S@ v > 0.16 Due to the

concavity of the value function with respect to e

S, we have that

Taking

@

@S2w

V w < 0, and

@

V

@Sw @ v w

@

@S2w

w

V w dS

@S@w @ v V w 0.

dv

By

concavity

Footnote 16). Hence dSw =dv > 0 as required. As the bonus cap does

not apply to retail banking, the reaction function of bank r; Sr Sw is

unaffected by v.

Reducing v will push the intersection of the reaction curves

towards greater retail banking assets if the equilibrium is stable

(Tirole (1988)) so that 1 < dSi Sj =dSi < 0 for all i j. This can be

conrmed by explicit differentiation of (18):

0 2c

kG

c n

o

g

The result follows if a1

1 c 1v v is decreasing in v. Differentiating with

v

respect to v yields

differentials,

g c

dSw Sr

kG

cc 1 h

a

dSr

g c

cc 1 h

1

1v

T r Sr

Sw

1

r

1 v T rSS

w

ic2 v

2 Tr

ic2 v

2 T r

Sr 2 dSw Sr

dSr

S3w

Sr

S2w

16

g

a1 v

c "

1v

cv

1 v

Simplifying, for c large enough we guarantee that dSw Sr =dSr > 1.

In particular a sufcient condition for the result to hold is (6)

using the fact that T i Si < Sj for ij by construction. The proof

that dSr Sw =dSw > 1 is analogous. Hence we have the desired

result. h

10.1016/j.jbankn.2014.04.004

secure the better wholesale banker. Suppose, for a contradiction,

that the bank selects T r Sr < Sh assets for its wholesale banking

book. In this case the value of the bank is given by (8). This is concave in Sr . The rst order condition for this expression would set

Sr Syr . Hence bank r would have assets T r Syr in its wholesale

banking book. But this is in excess of the hedge funds assets, Sh

by (7). Hence we have a contradiction and so the bank must prefer

an asset allocation to wholesale banking which was sufcient to

secure the better banker.

With no remuneration caps the banker would be paid a bonus

rate of 1 b=aSh =T r Sr , which follows from (12). Bank rs

expected value is then, adapting (17):

V r Sr ; Sh a 1 1 b=a

0

Sh

T r Sr

T r Sr

k T r Sr G@

h

a 1 1 b=a T rSS

r

1c

A aSr

|{z}

i

g c

kSr G

c Sr T r S r

19

proof of Proposition 5. Hence the objective function of the bank is

concave and so has a unique maximand given by the rst order condition. The rst order condition with respect to Sr delivers

0

1c

d

g

A

V r Sr ; Sh kG@

dSr

h

a 1 1 b=a T rSS

r

2

3

1

S

h

5

1 b=a

41 c

T r Sr

h

1 1 b=a T rSS

r

g c

c T r 2Sr

kG

Algebraic manipulations deliver that dSdr V r Syr ; Sh < 0 using (7).

Hence the optimal size of the wholesale banking book is greater

than T r Syr , and so the assets devoted to retail are below Syr , yielding the result. h

Proof of Proposition 9. The hedge fund is willing to bid up to a

bonus given by (11) as qh;1 1 b=a. Hence the hedge fund would

be willing to offer the a-banker an expected utility of up to

aqh;1 Sh a bSh . To hire the better executive the bank needs to

match this remuneration. This occurs if aqr T r Sr P a bSh .

If the remuneration cap is binding on the bank then the better

executive can only be hired if T r Sr P 1 b=aSh =v. Suppose

the cap is sufciently severe that the wholesale banking book is

optimally below this level.17 In this case the bank cannot outbid

13

the hedge fund. The bank will therefore secure the b-banker to run

its banking book. In this case the banks value is given by (8). Optimising this value over the asset allocation, the optimal wholesale

banking book size is then given as Syr . The wholesale banking book

has shrunk and the banking book grown by comparison with the

bound in Lemma 8. h

References

Acharya, Viral, Gujral, Irvind, Shin, Hyun Song, 2009. Dividends and Bank Capital in

the Financial Crisis of 20072009. mimeo NYU Stern.

Acharya, Viral, Pagano, Marco, Volpin, Paolo, 2013. Seeking Alpha: Excess Risk

Taking and Competition for Managerial Talent. mimeo NYU Stern.

Bank for International Settlements, 2001. Report on the Consolidation in the

Financial Sector. <http://www.bis.org/publ/gten05.pdf>.

Bannier, Christina, Feess, Eberhard, Packham, Natalie, 2013. Competition, Bonuses,

and Risk-taking in the Banking Industry. Review of Finance 17, 653690.

Basel Committee on Banking Supervision (BCBS), 2010. Basel III: A Global

Regulatory Framework for More Resilient Banks and Banking systems, Bank

for International Settlements.

Benabou, Roland, Tirole, Jean, 2013. Bonus Culture: Competitive Pay, Screening, and

Multitasking. mimeo Princeton University.

Cheng, Ing-Haw, Hong, Harrison, Scheinkman, Jose, 2010. Yesterdays Heroes:

Compensation and Creative Risk-Taking. NBER Working Paper No. 16176.

Edmans, Alex, Gabaix, Xavier, 2011. The effect of risk on the CEO market. Review of

Financial Studies 24, 28222863.

Edmans, Alex, Gabaix, Xavier, Landier, Augustin, 2009. A multiplicative model of

optimal CEO incentives in market equilibrium. Review of Financial Studies 22,

48814917.

Fahlenbrach, Rudiger, Stulz, Rene, 2011. Bank CEO incentives and the credit crisis.

Journal of Financial Economics 99, 1126.

Foster, Dean P., Young, H. Peyton, 2010. Gaming performance fees by portfolio

managers. Quarterly Journal of Economics 125, 14351458.

Financial Services Authority, 2010. Revising the Remuneration Code, CP10/19.

Financial Stability Board (FSB), 2011. Policy Measures To Address Systemically

Important Financial Institutions. Financial Stability Board: FSB Publications.

Financial Stability Board (FSB), 2009. Principles for Sound Compensation Practices.

Financial Stability Board: FSB Publications.

Freixas, Xavier, Rochet, Jean-Charles, 2008. Microeconomics of Banking. MIT Press.

Gabaix, Xavier, Landier, Augustin, 2008. Why has CEO pay increased so much?

Quarterly Journal of Economics 123, 49100.

Hart, Oliver, Jaffee, Dwight, 1974. On the application of portfolio theory of

depositary nancial intermediaries. Review of Economic Studies 41, 129147.

Iannotta, Giuliano, Pennacchi, George, 2012. Bank Regulation, Credit Ratings, and

Systematic Risk. mimeo University of Illinois.

Llense, Fabienne, 2010. French CEO Compensations: What is the Cost of a

Mandatory Upper Limit? CES IFO Economic Studies, http://dx.doi.org/10.1093/

cesifo/ifq002.

Morrison, Alan, Wilhelm, William, 2008. The demise of investment banking

partnerships: theory and evidence. Journal of Finance 63, 311350.

Philippon, Thomas, Reshef, Ariell, 2012. Wages and human capital in the US Finance

Industry: 19092006. Quarterly Journal of Economics 127, 15511609.

Pyle, David, 1971. On the theory of nancial intermediation. Journal of Finance 26,

737747.

Resnick, Sidney, 1987. Extreme Values, Regular Variation, and Point Processes.

Springer-Verlag, New York.

Rochet, Jean-Charles, 1992. Capital requirements and the behaviour of commercial

banks. European Economic Review 36, 11371178.

Sanders, Robert, 1988. The Pareto principle: its use and abuse. Journal of Business

and Industrial Marketing 3, 3740.

Thanassoulis, John, 2012. The case for intervening in Bankers pay. Journal of

Finance 67, 849895.

Thanassoulis, John, 2013a. Industry structure, executive pay, and short-termism.

Management Science 59, 402419.

Thanassoulis, John, 2013b. Safety in Numbers, Financial World, May 2021.

Tirole, Jean, 1988. The Theory of Industrial Organization. MIT press.

Wagner, Wolf, 2009. Diversication at nancial institutions and systemic crises.

Journal of Financial Intermediation 19, 373386.

17

This is true in the limit as v tends to 0. Therefore there is a range of bonus caps for

which it is true by continuity.

10.1016/j.jbankn.2014.04.004

## Гораздо больше, чем просто документы.

Откройте для себя все, что может предложить Scribd, включая книги и аудиокниги от крупных издательств.

Отменить можно в любой момент.